The Issues With Investing in Chinese Companies

Earlier Comment: from “Early Signs of Negative Wealth Effect” at Rogermontgomery.com on 7 February 2019

[In an earlier comment on this thread] I inferred that I had used the weakness in stocks at the end of 2018 to buy into numerous Chinese stocks, and that I felt that the tough conditions ahead would benefit these companies to sharpen their competitiveness. I had done this, but I have now reversed full throttle and below I explain why.

I have long felt that Chinese companies would be successful going forward – because of the size and growth of their own domestic markets, the way in which China was increasingly interacting with especially the developing world, and because of the Chinese-specific factors that everyone at least partly understands (ie the heavy hand of Government).

As early as 10 years ago when I wrote a piece on the Australian property bubble, which Steve Keen posted on his website, I have been of the belief that there is no reason why that final point would ensure that it is all smooth sailing for the Chinese economy and their companies and markets. I had this in mind when I invested and accepted that.

In recent years I have taken particular note of people who I admire greatly as investors and economic thinkers (eg Roger M, Charlie Munger, Grantham and others) in forming an opinion that I wanted to have a high weighting to Chinese companies for future growth potential. And last year’s falls created an opportunity to buy in at lower prices.

However, I have to admit that there was an extra unease inside of me as I loaded up especially on Chinese tech and automobile (around EV and autonomous), tech infrastructure, industrials (plumbing goods), and education companies.

I was fortunate to spend a month in China around 20 years ago, while I worked for the Australian federal Government, for an APEC training workshop. It was an interesting insight into the country that has emerged as our most important trading partner.

At 30 I was one of the youngest workshop participants – some attendees were in their 50s – and the first night that we stayed out later than the “recommended” time for lights out it became clear that it was not a recommendation but an enforced curfew! The second time that we were late, around a week after the first time, we were walking back to our accommodation about 30 mins after “curfew” and it become clear that the short stocky man who was taking photos throughout the workshop, and was that night a pillion on the motor cycle of the junior staff member, was laying down the law to that staff member and was very, very cross with our “insolent” behaviour. (Imagine professional men ranging from 30 to 60 years of age constantly checking watches to ensure that we were not late for curfew!)

After that incident, the next day the “photographer” entered the room and from 3 rows of desks in front of me took photographs with me in the centre of the frame. I covered my face acting as if in deep contemplation. The next day he came into the room again to take photographs, but this time squatted down immediately in front of my desk and made it clear that he would take a photograph of me if he so chose.

The small family restaurant that we were frequenting to have one or two beers between supper and “curfew” received two visits from black limousines while we were there. Men in dark suits entered and spoke with the owners after shutters were pulled across to cordon off half of their restaurant.

Also, when I worked in Thailand for a multi-national organisation under the auspices of the FAO I had an interesting and memorable conversation with a Chinese national colleague, who had quickly become a good friend, about Taiwan/Taipei.

With these experiences, I have watched concerningly whenever the level of interference by China into our political system has become apparent.

I also noted the changes that Xi made last year to prolong his stay at the helm, and I was particularly interested and concerned by Soros’ recent speech at Davos.

The truth is that while I am no fan of Donald Trump as an individual, I do think that pushing back on China is long overdue, and I respect his administration for it. I think that I would feel far more comfortable with the world if the US continues what it has begun. I suspect it will happen because Trump’s administration has crashed through the “group think” that had prevailed on China. I certainly hope that China’s main advantage – short-termism for political expediency by western democracies – does not return to the US or allies over this issue.

With that in mind, I not only think that we have begun a historic reframing of China’s engagement with our western allies, I very much want it to happen. As such I feel I cannot on the other hand seek to profit from China continuing to rise.

Attempting to do so will throw up all sorts of conflicts and already did. For example, while researching one of the EV companies that I was invested in I learned that it also produced military vehicles!

Now I realise that there are many western companies that at least partly depend on military sales.

But I do think that increasingly, as this relationship is reframed, we are going to have to navigate the shifting ground carefully as individual investors and at a national level (certainly that many interested observers, like myself, now understand from newspaper articles what the “five eyes” means is indication of that). For me I would rather be early than risk being caught in a rush for the exits when the crowd realises how the environment has become much more complicated and volatile.

I should also admit that my concerns were probably showing through in a question I posed on one of Roger’s posts at the end of last year when I inquired whether the Montgomery team was taking the opportunity to increase exposure to Tencent at cheaper prices or was concerned by a reframing of the wests relationship with China – and I have noted since in investment updates that exposure to Tencent has not been increased.

Fortunately, coming to this realisation did not result in a financial penalty for my family – it actually yielded a fairly nice short-term return – but I do wonder whether this is a widely underestimated issue that will ultimately affect returns over the medium to long term. I guess I hope it does because that will mean that what I consider to be a dangerous drift in geopolitics will have been contained or slowed.

I accept that these actions could be seen as an over-reaction – however, as a personal investor, not a professional with career risk at play, I am “allowed” to turn full circle on a dime, and it has usually worked out OK for me when I have done so. (If I wish to put a positive spin on it I would say that I tend to act decisively once I’ve decided, and am not afraid to admit if my opinion has changed, but hindsight is usually the best “judge” of that.) But I have to admit that while I was feeling good about buying into reasonably valued companies in the areas in which I have greatest conviction – as opposed to buying into mostly overvalued ones in developed markets – I do feel a whole lot better about my positioning now (which has resulted in me increasing cash weightings again to about 50%! – between September and December I had gone from less than 20% in equities to a high of close to 70%)

Comment on 14 February 2019 at One Important Aspect of Active Portfolio Management:

As I said [earlier], in this recent period I went from less than 20% in equities to around 70%… but I have already taken profits on my (considerable) China and wider EM positions as I want to see how the current reframing of the West’s relationship with China progresses, and because I want to be a lot more thoughtful as to my views on the ethics/risks of investing with companies arising from non-democratic authoritarian systems. My own personal experiences have never sat comfortably in this regard.

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© Copyright Brett Edgerton 2019